Is incorporation worth it?

Is it worth it to incorporate or to form a limited liability company? For many businesses, the answer is probably no.

There is a myth – a dangerous one, actually – that the formation of a limited liability entity (LLC/corporation) protects the owners from getting sued. This is mostly false. There are a number of ways to get around the limited liability shell: theories of negligence aimed at the owner as manager/worker, theories of negligent entrustment of say a company car to an obviously negligent employee, in some states piercing the corporate to protect an undercapitalized entity from harming a “paramount equity”, professional liability that cannot be ducked through a limited liability shell, co-signatures on debts or credit accounts (usually required for new businesses, etc.) In some states, if an LLC or corporation acts beyond its narrowly defined entity purpose as stated on its charter, in some states its acts may be considered the acts of individuals and not of the company, i.e. direct personal liability. A corporation or LLC may lapse through failure to pay annual franchise taxes, or failure to hold regular meetings and make annual accounting statements properly, depending on the state.

None of this makes a limited liability company or a corporation per se a bad idea; some protection is better than no protection and it’s not necessarily easy to get around the limited liability shield in all cases. But the idea that a negligent driver can mow someone down on a street, then claim no personal liability because he was doing the business of the company that he owns, is preposterous – even if he was driving a car titled in the company name.

The following factors (among others) increase the usefulness of corporate/LLC liability protection:

1) Multiple employees
2) Hazardous materials or activities
3) No co-signatures needed from main creditors/lenders (rare for new business)
4) No professional liability (i.e. lawyers and doctors generally cannot get out malpractice exposure through limited liability)
5) Multiple owners currently or anticipated
6) Specific intent to sell the business at some point
7) High capital investment in the business (i.e. a shoestring business more likely to be considered “undercapitalized” anyway.)

The downside of limited liability company and corporation protection: annual franchise fees, accounting and paperwork compliance, probably increased tax compliance, exposure to some additional taxes (for corporations, salaries of owners are subjected to unemployment taxes in MD and many other states and for C corps, potential double taxation).

There is for some owner-operators a tax advantage in using an S-corp, namely the lack of self-employment taxes or their equivalent on profits about the owner’s salary. This is more likely to be beneficial in companies well-leveraged with employees where the owner can credibly claim that the profits came from the activities of others, not of herself. If you are the only employee in the company, it’s hard to argue that your compensation is a return to your capital (i.e. no employment taxes) rather than to your labor (i.e. taxed for FICA) unless your business is unusual, heavily capitalized or relies heavily on passive income such as rent or royalties. For many businesses, the S-corp doesn’t provide much help. Professional service corporations that organize under subchapter C do get some tax advantages in terms of benefit plans but their profits are subjected to brutally high federal taxation rates above the ordinary subchapter C rate brackets.

One advantage of a corporation is that for some taxpayers, the business may look less attractive for an audit. A self-employed person netting pre-tax $120K off of $190K gross looks “juicier” for an IRS audit than does an employee making $100K salary and a minimal K-1 profit, and a business corporation paying her maybe $7-8K in profits (after employment taxes) off of $190K in gross revenue. But for many start-ups, this is not the likely profile.

For professionals, it’s unlikely (though conceivable) that a purchase price exists practically for the solo practice, incorporated or not, when it’s even permitted ethically; more likely is a merger with another practice and even more likely in many professions is the abandonment by the professional of the prior solo practice entity and joining with the new one, stripping the “portable” client work and maybe bringing some physical assets from the professional corporation or LLC along for the ride. A limited liability entity makes this process more complex in terms of accounting and wind-up.

For entrepreneurs looking to build up their businesses and get bought out, LLCs and C-corporations are the best bet; S-corporations are limited in their number of owners and cannot be owned by non-resident foreign corporations or individuals. But many small businesses don’t have that as a goal for a number for reasons and for many of those businesses, corporate or LLC formation is not particularly useful. Even for businesses that have limited liability protection, nothing beats insurance that covers the business, its owners and the officers/directors (so-called “D+O” coverage.) That coverage should be a priority for any business that actually cares about limited liability.